The FASC’s Comments on the SEC Roadmap

Last week, a revised version of “A Research Based Perspective on the SEC’s Proposed Rule on Roadmap for Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards (IFRS) by U.S. Issuers,” comments from the Financial Accounting Standards Committee of the American Accounting Association, appeared on SSRN. In this post, I offer a few observations on this paper.

While I am currently the FASB Research Fellow, I emphasize that these comments are my own and do not reflect official positions of the FASB.

“Is there a need for a single global set of financial statements” [I believe the authors meant to say "financial accounting standards".]

The paper states: “Our view is that comparability and consistency should not be the main goals of financial reporting.” It goes on to explain in some detail two perspectives on the purpose of standards, a minimum quality function and a coordination function. In my view, this line of argument is a red herring. I don’t believe that the FASB nor the IASB nor proponents of a single set of global standards think that that comparability and consistency are the main objectives of financial reporting.

In fact, the accounting standards currently endorsed by the SEC for regulatory reporting and the standards used in most of the world (U.S. GAAP and IFRS) are based upon conceptual frameworks that clearly identify decision usefulness as the primary goal of financial reporting. In the well-known figure, “A Hierarchy of Accounting Qualities” in FASB Statement of Concepts No. 2, comparability and consistency are labeled as “secondary and interactive qualities.” Paragraph 34 of FASB Statement of Concepts No. 1 and paragraph 12 of the IASB “Framework for the Preparation and Presentation of Financial Statements” both identify the objective of financial reporting as providing information that is useful in decision making; neither paragraph makes any mention of comparability or consistency. Moreover, the joint IASB-FASB conceptual framework project’s Exposure Draft, “The Objective of Financial Reporting and Qualitative Characteristics and Constraints of Decision-Useful Financial Reporting Information” reaffirms this primary objective: “The objective of financial reporting is to provide financial information about the reporting entity that is useful to present and potential equity investors, lenders and other creditors in making decisions…” (paragraph S2 of the ED).

Rather than debating the objective of standards, a more productive framing of the question is the following: given standards whose primary objective is facilitating the production of decision-useful information, would added comparability and consistency across national borders provide incremental benefit to financial statement users?

Turning to that question, I agree with the observation made in the paper that extant academic research supports the argument that standards are just one of many factors that influence the degree of comparability of financial reports. Other factors, such as incentives and institutional and cultural differences are likely more important. This evidence supports the conclusion that common global standards alone are likely insufficient to guarantee comparable financial reports.

However, the absence of global standards will also be likely insufficient to guarantee comparable financial reports. Hence the question is not whether global standards will lead to perfect comparability but rather whether increasing the uniformity of standards and reducing the degree of permissible variation will lead to more comparable financial reports. Rejecting global standards on the basis that they cannot lead to perfect comparability ignores the potential incremental improvements in comparability that many believe may result from global standards.

“Robust Competition Between Standard Setters”

The paper puts forward the idea that standard setters should compete by allowing issuers to choose between IFRS and U.S. GAAP. If indeed the world of standard setting resembled the theoretical notion of “perfect competition,” it would follow that such a setting would lead to innovation and quality improvement that market participants want from accounting standards. However, in many important respects the present configuration departs from that theoretical depiction.

There are but two major standard setters. Each currently operates as a regional monopoly, as each is designated by governments in selected countries as the creator of standards for capital market purposes. The IASB and FASB have worked closely together since the IASB’s inception on standard setting, and their standards derive from conceptual frameworks that are quite similar. These are clearly attributes that depart from the notion of a perfectly competitive market for accounting rules.

As a result, it is hard to imagine what a full-scale competition between them might look like. Given their histories, the constituencies that they serve, and their highly overlapping philosophical views about accounting standards, I don’t envision that left entirely separate there would be meaningful differences in the standards that they would set. However, we have recently witnessed a limited amount of competition that has proven to be destructive to the quality of accounting standards. Under pressure caused by the global financial crisis, selected constituent groups combed IFRS and U.S. GAAP in search of slight differences in accounting for financial instruments, and when some were found, they put extraordinary pressure on the standard setter with the stronger, higher-quality standard to weaken the standard to match that of the lower-quality standard. This is often referred to as the “race to the bottom.” Surely this is not the kind of outcome that is desired, but it seems to be the natural result of “competition” between two regional monopolies. Whatever the relative weaknesses of a single standard setter, at least such a configuration would not be subject to this particular weakness.

Finally, any evaluation of the proposal to allow choice between standards must fully take into account the aggregate societal costs of maintaining the flexibility needed to make that possible. These costs include training of all financial market participants to be fluent in both IFRS and U.S. GAAP, redesigning contracts so as to be able to be flexible for different measures that would result from different standards, expansion of the capabilities of regulators, investors, creditors, and other users of financial statements to be able to accurately comprehend the meaning of financial statements prepared under two different bases of accounting, and other related costs. I don’t believe that the paper adequately sorts through these costs in comparison to the anticipated benefits of multiple sets of standards.

Clearly the future direction of global standard setting is an issue of great importance for the U.S. and other nations. Continued thoughtful debate among academics and others is an important part of a process that can lead to wise policy choices by those who will ultimately make the decisions. However, it is crucial that such debate be informed and that arguments be made carefully and realistically consider the important complexities that are part of a proposed transition of this magnitude.

Ray Pfeiffer

Ray Pfeiffer is Professor of Accounting and chair of the accounting department at the Neeley School of Business at TCU Since July 2009. He was the FASB Research Fellow from July 2008 through June 2009 and prior to that was a Professor at the University of Massachusetts. His primary teaching and research interests lie in financial reporting, specifically issues concerning capital market participants' use of financial accounting information, and financial reporting regulation.

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4 comments on “The FASC’s Comments on the SEC Roadmap”

I received an email response to Ray’s post, and the author has asked me to publish it anonymously. We are willing to do this when circumstances make it necessary. (In this case, the author has a professional position that doesn’t allow attributed remarks.)

Does the SEC and FASB plan to propose alternative criteria for IASB acceptance? For 25 years the mantra has been comparability, consistency, transparency, and disclosure. Perhaps SEC/FASB has been disingenuous: holding out for comparability (another word for bookkeeping uniformity when you really probe it), consistency (not certain what it really means but it’s more than similar cross-period application), transparency (usually associated with IASB process), and disclosure (an euphemism for regulators’ ability to add to Regulation S-X if they don’t like what standards-setters do) while they really have an agenda unrelated to those qualities. Is there another agenda?

Do the Boards now agree they have created a “perverse” market where competition leads to the lowest common denominator rather than to a range of quality on different dimensions as in orderly markets? We know about markets for lemons. Are there other markets where competition is detrimental? Perhaps we should study them. How would anyone know if we’re not already at the LCD with the current arrangement?

Cost arguments related to public goods are virtually always excessively speculative, although usually lots of fun! Others might say that they underestimate the social welfare costs of monopolies. Impossible to tell much of anything. It’s surprising that the proponents of monopoly standards setting do not invoke more aspects of public goods arguments. Because it’s hard to extract adequate private benefit from public goods (free riders, externalities, etc.) to compensate for the private investment, in the absence of government intervention there is an inadequate investment in the good. In this context, I’m reminded of Robert Reich’s piece in this morning’s WSJ where he argued that government engagement in health care as an alternative (rather than a substitute) would force greater competition into health care, which has also become a public good in our society. What makes accounting so different from health care?

As the principal author of the AAA’s Financial Accounting Standards Committee (FASC) report on the Roadmap that Ray commented on, I am pleased to see our comment getting some recognition. Let me elaborate on some issues. As usual, the comments reflect my personal views and not those of AAA or the FASC committee.

There are broadly speaking two types of functions that standards serve. One is to set minimum quality standards and the FASB’s rhetoric about decision usefulness is a quality type argument. The second is to set co-ordination standards. Comparability and consistency are co-ordination type arguments. For quality standards, there is a presumed notion that standards can be ranked and the “best” standard can be chosen. For co-ordination standards there is no best standard but a sense that a society gets “locked-in” once a standard is chosen (e.g. drive on the right side of the road).

The discussion about top down standard setting in accounting is driven by a natural monopoly type of mindset. In the short run it seems obvious that a monopoly can do a better job of co-ordinating activities and generating efficient solutions. However, the concern is with a long run focus on innovation. Once a standard setting body builds up a base of knowledge and operating procedures, it becomes resistant to new ways of thinking and new technologies. This is why most monopolies fail in the economy and the same danger applies to standard setting in accounting as well.

Some authors are not willing to concede even a short term advantage for a monopoly standard setter especially for quality standards (e.g. Kothari, Rammana and Skinner 2009 – available on SSRN). Since accounting has to satisfy needs of multiple users, it is not clear that a council of experts is the best mechanism for identifying the best accounting and trading off the needs of diverse user constituencies.

In our Monopoly vs Competition working paper (on SSRN), Jamal and Sunder present a case study of the Telephone system. The ITU was a global telephone standard setter which had a global monopoly backed by Governments all over the world.They developed a sophisticated (though costly) telephone system that worked well all over the world. However, it turned out that new technologies allowed an alternative way of transmitting phone calls over the internet. The existence of a rival standard setter (you only need one rival – in this case the IETF) created the standards which now route all telephone calls over the internet and made possible skype, google talk etc. Its pretty clear that the ITU would not have destroyed the installed assets of global telephone firms to support an internet based phone system.

So the basic idea of competition is not that current standards have to be bad (though there are many people willing to argue this), but that a monopolist gets locked into one way of thinking (with conceptual framework, definitions etc) and then just becomes closed off to alternative ways of thinking.

The best thing for accounting would be to have IASB, FASB, and possibly other national standard setters competing with each other (looking for the best solution) rather than just trying to converge with each other. The IASB’s insistence on being principle based, as opposed to the presumed rules based orientation of the FASB is one dimension on which the 2 standard setters could compete, if they wanted to.

The interesting irony of our telephone example is that innovation occurred in a co-ordination standard (usually benefits of innovationa re thought to occur only for quality standards), and the presence of the rival standard setting body reduced costs and increased functionality of communication devices. It is not “more costly” to have competition, it actually reduces costs.

Your categorization of quality and coordination standards seems similar to, but distinct from, the following categorization of performance standards and technical standards, written by Kevin Werbach of Harvard, published in ‘Higher Standards: Regulation in the Network Age,’ 23 Harv. Journal of Law & Techology(forthcoming 2009):

A standard is a common specification or model for market participants.Such technical standards should be distinguished from performance obligations set by regulatory agencies.Regulations such as the Department of Transportation’s fuel economy requirements for auto manufacturers, or the Environmental Protection Agency’s acceptable levels of particulate matter in drinking water, are not really standards at all. They do not specify a common mechanism for companies to employ in order to reach those levels. Another way to put it is that a performance standard defines outputs;a technical standard defines inputs. Performance standards are a staple mechanism of the administrative state. Technical standards,the focus of this Article, are usually developed in the private sector.

Technical standards are essential to the communications,computer, and Internet industries. By their very nature, these industries involve connections between software, hardware, content,and services of different providers. No company, no matter how dominant, can totally avoid interfacing with someone else. Systems must therefore have interfaces. The more standardized those interfaces, the easier it is to connect with them. The shift from monopoly to competition in telecommunications, integrated mainframes to independent hardware and software in computing,and private data networks to the Internet all greatly enhanced the importance of standards.

It sounds like Kevin Werbach would say that performance standards are similar to your quality standards; and clearly technical standards have a strong coordination role. But it seems to me an open question as to whether accounting standards are technical standards or performance standards–and perhaps this is where you and Shyam part ways with the Boards. I think the Boards (and the SEC) view accounting standards as performance standards, ensuring that outputs meet quality thresholds. As such, they are (in Kevin’s words) “a staple of mechanism of the administrative state.” Since states naturally have monopoly power over law and regulation, competition doesn’t really figure in.

To view accounting standards as an appropriate venue for competition, it seems you would need to make one of two arguments. First, you could view accounting standards as technical standards that somehow govern inputs (and thereby placing accounting standards in the realm of those that are usually developed in the private sector). I am not quite sure how this works, but it wouldn’t be unthinkable. Perhaps one could argue that financial statement users plug data from financial statements into their models, creating a network of informed users, who then wish to haggle about the best standards for integration.

The alternative tack would be that performance standards simply shouldn’t be an appropriate subject of regulation, or that regulation in general should be competitive. I know that libertarians generally argue against regulation, and advocates of states’ rights in the US have argued for the benefits of letting states be laboratories for experimentation. But I am not sure these arguments will be very persuasive with the Boards (or SEC).

I wish there was such a nice simple differentiation between standards set by Government vs Private Sector. I havent read the article you cite but we spent a lot of time looking at over 100,000 standards set in the economy and found no clean differentation like this.

What we found is a clear trend over time of having the Government withdraw from standard setting activities in the US. During the 1990s in particular there was a marked shift in standard setting activity being transferred from Government agencies to private standard setting organizations. Maybe that trend will reverse now , though historically when there has been a spike in government standard setting (e.g. the 1910′s, 1930′s, 1970′s), there has also been a corresponding spike in private standard setting as well.

If you look across countries there is also no consistency in terms of what is done by government versus private sector. We cite a paper comparing Sweden and the U.S. where a series of case studies were done in standard setting domains where the respective standards are set in the public (private) sector in Sweden and the opposite in the U.S.

Your fuel economy standard can also be categorized as follows:
the government sets an output standard- vehicle fleet must get at least X miles per gallon. However, the government also specifies how miles per gallon will be measured (input standard?). The auto companies used to drive their cars around a racetrack and then report their fuel efficiency numbers. The government regulators accepted these measures.
Consumers Report refused to accept this measurement standard and came up with a “real world fuel economy” measure where they took a survey of drivers and then test drove cars in accordance with the survey results (some in rush hour, some on weekends, some on highway, some in the city)- this usually resulted in much lower fuel efficiency measures. Recently, the government adopted the same measurement criteria as consumers reports.

It is quite common for private sector standard setters to overlap with government agencies (there is no complete monopoly) not only for fuel efficiency but also food, movies, games and a host of other rating activities. If the government (or industry) regulator says a movie is rated PG, there is some competing private sector rater willing to argue the movie is not suitable for families etc.

In many areas such as the environment, safety etc, these private standard setters are more credible than their government counterparts. You could argue that Ralph Nader was a private standard setter for automobile safety who was a rival to the government safety regulators. In this case, Nader forced the government regulators to adopt better auto safety standards.

In financial reporting US GAAP allowed pooling of interest accounting for a long time after it had been disallowed in Canada and other countries. Eventually pooling was disallowed in the US as well. I hope the example from other countries had at least some effect in moving US GAAP on this issue.

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